Post Brexit: Uncertainty Prevails – commentary from Jim Power

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Commentary and Updates from Friends First Chief Economist Jim Power

Post Brexit – Uncertainty Prevails

In recent months all international bodies recognized the significance of the impending UK referendum on EU membership and warned of the dangers of UK exit from the system. The UK has the 22nd largest population in the world, but has the 5th largest economy (or 6th depending on how it is measured). It has been a member of the EU since 1973 and has had a very significant and arguably benign impact on the manner in which the zone has developed. The UK has a basically pro-business economic model and this has been a good counter-weight in the EU.

While the opinion polls increasingly suggested in recent weeks that Brexit would occur, the result has still come as a shock. June 23rd will go down in UK and European history as a day of extreme significance that will fundamentally reshape the future of the UK and the EU in many respects. Many of us will remember where we were on the morning of June 24th.

Business investment in the UK will now undoubtedly suffer in the short-term at least due to the uncertainty over what is now likely to transpire. This has been a feature of the UK economy in recent months and now that the risk has materialized, it will become an even greater uncertainty over the coming months. The UK economy has slowed over the past year and the possibility of a recession looks like a reasonably high probability event in the near-term.

The future of the UK itself is now under serious threat. Scotland and Northern Ireland both voted to remain in the EU, so another Scottish independence referendum looks inevitable. Scotland or Northern Ireland could in certain circumstances become independent members of the EU. This would effectively mean the end of the UK as we know it.

In terms of the future viability of the EU, there are now massive risks. The loss of the 5th largest economy in the world and the loss of 1 of just 5 AAA rated countries in the EU-28, is a significant shock for the EU and will certainly test the viability of the whole project in the longer-term. The obvious risk is that if a precedent is created, other countries might just decide at some time down the road that exiting the system would be a viable option. Keeping Greece in the Euro Area over the past couple of years, against all of the odds, was recognition that the glue that has kept the euro project together through very difficult times after 2008 was a belief in its irreversibility. If this belief had been undermined by a Greek exit, the whole edifice could have come crumbling down. Likewise with the EU – if one country were to leave, then the irreversibility of the project could be seriously tarnished.

The big challenge now for the EU-27 is how it treats the UK. If exit were made an easy process then that would create a dangerous precedent. The EU now faces a major dilemma in terms of how it should treat the UK exit. Inevitably, there will be many differing opinions across the EU-27. Ireland needs to be as supportive of the UK as possible.

The referendum campaign itself was very nasty and was characterized by an incredible level of misinformation and xenophobia on the ‘leave’ side in particular. Issues around the impact of migration took centre stage on the ‘leave’ side and it basically treated economic issues in a manner that suggested a very high level of economic illiteracy. A price will now have to be paid for that approach.

The Brexit campaign has clearly demonstrated that there is a large cohort of the UK population that is deeply sceptical of anything to do with the EU. This would make it difficult to hold another referendum anytime soon, even under a Labour government, unless the EU takes on board why the UK electorate has become so disaffected, and indeed the same can be said for many other electorates across the EU.

For David Cameron, the defeat has ended his political career. His successor will have to deal with a Conservative party that is now considerably more divided than in the past, and that is saying something. Any sensible person would recognize that the EU is a deeply flawed structure that needs fundamental reform if it is to deliver what it is meant to deliver. One would hope that the UK vote will force the EU elites to wake up to the reality that fundamental change and reforms are needed if the EU is to avoid going the way of the dinosaur.

Following the Brexit vote the UK and the EU are facing a fundamental crisis of confidence unlike anything seen in decades. This has the potential to cause enormous uncertainty, volatility, political dislocation and economic damage.

From the perspective of financial markets, apart from some minor jitters over recent months, there was a strong sense of calm and lack of concern in the weeks leading up to the vote, despite what the polls were suggesting. On the evening of the referendum sterling was trading at 76.7 pence to the euro, having been up at almost 81 pence in recent months; the FTSE 100 rallied by 1.23% during the day and was up 1.2 % year to date in local currency terms; and the 10-year bond yield was at a very low 1.37 per cent. None of this was suggestive of a market concerned about the possibility of Brexit. Following the result, the FTSE 100 has lost 2.4% (which represents a recovery from earlier losses), sterling has been up at 83.18 pence, and is currently trading at 80.6 pence, and the 10-year bond yield is down at 1.1%.

Global markets would also have taken a serious hit, because Brexit could represent a massive shock to the EU and could now create serious uncertainty in a global economy rife with uncertainty. There is still much to worry about at a global level, including China and the emerging economies; the sluggish growth performance of the Euro Zone; US interest rate policy; the impact of Quantitative Easing; terrorism; and strange geo-political developments in many countries. There is now even more to worry about.

From an Irish economic and political perspective, there is much to worry about in relation to Brexit. The impact on sterling and hence on the competitiveness of the Irish merchandise and service export relationship with the UK; the future trading relationship that would be negotiated between the UK and the EU over a protracted period; the border with Northern Ireland; the implications for the all-island energy market; and the future of UK corporation tax policy. Ireland is now also about to lose a strong and sensible ally around the EU table, particularly in the face of the strong Franco-German axis.

David Cameron will step aside as leader of the Tory party and Prime Minister over the coming months. His replacement will then apply under Article 50 of the Amsterdam Treaty to leave the EU. At that stage a two-year period of negotiation will begin among the other 27 EU countries to determine what sort of trading relationship the UK will have with the EU. If agreement is not reached in that two-year period, the UK will have to apply for an extension, subject to the approval of the EU-27, or failing that; it would then most likely have to adopt WTO trade arrangements.

Uncertainty is now the only valid term that should be applied to the world in the immediate aftermath of the decision by the UK electorate. We are not going to wake up any morning soon to discover that the world has changed suddenly. In fact it will be life as normal until the negotiations conclude. However, uncertainty will be rampant from here on. This will damage economic and business sentiment in the UK and the rest of the EU.

From an Irish economy perspective, the key issues will be:

The impact of an inevitable slowdown in the UK economy on exports to the UK. Irish owned industry exports 53% of its output, with 44% of that going to the UK. A slowdown in UK growth will obviously damage that.

Sterling is likely to become significantly more volatile over the coming months, with the likely bias towards a weaker UK currency. For Irish companies dealing in sterling, this will obviously be very challenging and difficult to manage.

Weaker sterling would damage exports to the UK, but could also have a significant impact on UK tourism to this country.

UK financial markets generally are likely to become much more volatile and an EU risk premium could become a feature.

Ireland could benefit on the FDI front, but this would not be sufficient to offset the potential negatives.

Despite what some might suggest, it is impossible to identify any economic upside from the result in the UK, Ireland or the EU in general. The key issue now is that it is very difficult to be too prescriptive, given how many political uncertainties now exist.

Jim Power

Analysis based on data available on 24th June 2016. The views and opinions expressed in this article are those of the author.